June 2009

Fresh Gold Price Highs Possible This Year Thanks to Inflation Driven Surge in Gold Investment

Growth in investment demand has been the primary driver of the rally that has taken gold from around $250 in early 2001 to peaks above or close to the $1,000 level in 2008 and 2009. This phenomenon is clearly reflected in GFMS’ data on World Investment - the sum of implied net (dis)investment, official coins, bar hoarding, and medals and imitation coins. For instance, during the 1993-2000 period, World Investment averaged 383 tonnes per annum, whereas over 2001-2008 it averaged 707 tonnes each year.

In approximate value terms, this represents a steeper jump from an annual average of just $4 billion to nearly $12 billion per annum.

This change has been primarily driven by booming investor interest in gold, a result of: the general decline in the US dollar since 2002; rising commodity prices (at least until mid-2008); concerns over the security of bank deposits following the near meltdown of global financial markets; more recently, the drop in short term interest rates to levels close to zero in the major advanced economies and growing concerns at the potential longer term inflationary consequences of unprecedented monetary and fiscal policy easing. The contrast between this economic and financial backdrop compared to that prevailing in the mid and late 1990s is stark. Back then the economic environment was characterised by low inflation, high real interest rates and an extraordinary bull market in equities.

Looking at what one might term the more “western” component of investment, which includes the implied elements and much of official coin demand, the change between these two periods is yet more remarkable. As the graph below illustrates, “western” investment (defined for simplicity as the sum of these two elements) rose from an annual average of just 104 tonnes in 1993-2000 to no less than 403 tonnes in 2001-2008. Conversely, investment demand from the “rest of the world” (for the purposes of simplicity, here restricted to bar hoarding plus medals and imitation coins) remained relatively stable, with the annual averages increasing only modestly between these two periods from 279 tonnes in 1993-2000 to 304 tonnes in 2001-2008.

This difference is not surprising because “western” investment, which essentially covers just Europe and North America, tends to be greater at times of higher and rising prices, while the Asian markets (broadly defined), which account for much of bar hoarding and medals and imitation coins demand, generally tend to see much stronger buying on lower or declining prices. Put otherwise, “western” investment tends to drive prices (higher or lower) whereas demand in the rest of the world generally tends to support a floor – although as has been seen over 2001-2009 - to date, a floor that is at successively higher price levels.

Looking at the second half of 2009, investment demand, and especially its “western” elements, which include activity in ETFs, futures and the over-the-counter market, is expected to remain the driving force behind gold price movements. Given increasing fears over the long-term inflation threat in western countries, we expect World Investment to see a massive increase this year, particularly from its implied net investment and official coins components. Indeed, GFMS forecasted in its May Quarterly 3-Year Gold Forecast that World Investment this year will exceed 1,500 tonnes or approximately $47billion, in the process carrying the price to new peaks in the second half of this year.

The Impact of the ‘Credit Crunch’ on The Industrialised World’s Jewellery Consumption

Introduction
Reviews of gold jewellery consumption typically focus on the price sensitive countries of the developing world, in particular India, because of their marked swings. The industrialised world’s more stable consumption, however, is still worthy of analysis. Firstly, it remains sizeable, at around 600 tonnes last year, and has the scope for massive change, having roughly halved since its early 1990s peak. Secondly, its relatively price insensitive nature means it has the active ability, at least in theory, to boost or undermine gold prices. The above implied demand loss of almost 600 tonnes had three main causes - background structural changes, higher and more volatile gold prices, and recent macro-economic problems. The explanation and importance of each follows.

Structural Trends
Consumption in the industrialised world has been falling since 1992. That it has done so in a smooth manner supports our belief that the bulk of losses were due to secular changes, such as market share loss by all forms of jewellery to other areas of discretionary spending, such as consumer electronics. Another example is consumers choosing to devote an ever greater percentage of expenditure when buying jewellery to elements other than precious metals, whether physical (such as diamonds) or intangible (such as the perceived value of a branded item). The long term slip in average weights also means more spent on labour charges as these on lighter pieces are higher per gram. On top of this, there has been market share loss by gold to other precious metals in several markets. (This does not imply the value of gold jewellery sales have been falling; a simple multiplication of the fine weight by the average price shows a strong uptrend in value, and margins have also trended upwards.)

The Gold Price Rally
Structural changes, however, cannot explain the acceleration in the decline from 2006. Instead, it seems fair to blame much of this on the gold price rally. Much of the resultant damage was transmitted via the trade’s management of margins as great attention has been paid to shaving the weight of gold to keep pieces below key price points, by switching from solid to hollow items and so on. There has also been an intensification of structural trends, for example incorporating more non-metal elements, such as small, inexpensive diamonds to boost apparent value.

The Financial Crisis
Whilst the gold rally was largely due to recent financial troubles, there are direct links between falling jewellery consumption and the recent financial and economic crisis. Our quarterly consumption series show a fairly clear acceleration in the pace of recent losses and, while steeper falls in say late 2007 coincided with rapid price gains, the yet steeper drop in the fourth quarter of 2008 was in tandem with lower prices, implying other factors being at work. Monthly data shows a yet clearer link to non-price factors. The decline in US gold jewellery imports, for example, sped up markedly from March 2008 yet prices were then easing. Changes in consumer spending or confidence instead look more relevant.

That the pace of consumption losses has sped up is partly due to greater efforts to minimise gold use, such as the recent more pronounced move to lower carats. There has also been further market share loss by gold to other metals, such as the US market’s shift to high end silver jewellery. That move’s focus on value, not weight, helps explain why silver’s losses globally to other forms of jewellery, such as steel, may have outweighed the gains through migration from gold. As a result, silver also suffered accelerating losses last year in the industrialised world, although on a lesser scale than gold. Gold benefited through substitution from platinum but this was largely just in the first half of 2008, when gold’s discount was over $1,000/oz, and was centred on the more price sensitive Chinese market.

A Conclusion
The impact of financial turbulence can be assessed by estimating how large industrialised world consumption might have been if it only had to face structural change. One method is to apply the average annual drop in the period 1996-2005 of around 2% to the years from 2006 to 2008. If annual losses then had been that modest 2%, jewellery consumption in 2008 would have been some 200 tonnes higher than our current figures. Given that economic problems are recent, it is probably fair to blame the bulk of these non-structural losses on the price. However, for 2008 alone a roughly equal billing for the two is perhaps a better stance, given the jump in the scale of the drop.

Looking ahead, further losses look hard to avoid, given bleak economic prospects, strong prices and ongoing secular changes. The exact scale of consumption’s drop will chiefly be a function of the first two but it is easy to envisage a scenario in which losses in 2009 head for 100 tonnes.